Currency Hedging as a Risk Management Strategy - Essay Example

Currency hedging at firm level adds share-holder values Introduction Exposure to exchange-rate risk is a key source of risk for international corporations. To lessen the affect of exchange-rate variations, it has been arrogated that multinational corporations can apply risk management strategies either through financial derivatives, or operational hedges. For instance, Schering-Plough in its 1995 yearly report (page 25) contends in accompaniment of sole use of operational hedges: “To date, management has not deemed it cost-effective to engage in a formula-based program of hedging the profitability of these operations using derivative financial instruments. Some of the reasons for this conclusion are: The Company operates in a large number of foreign countries; the currencies of these countries generally do not move in the same direction at the same time". On the other hand, many corporations with big universal networks, like IBM or Coca Cola, make wide use of derivative financial tools to hedge currency and thus increase share holder value. Financial or corporate risks are risks which stems due to the variations in prices. These risks are insidious, and directly or indirectly control the worth of a company. Great deregulation, competition at the international level, rates of interest and foreign exchange rate instability, along with commodity price separations which appeared from the late 1960s, compounded corporate vexations. This resulted in the altered significance of financial risk management in the years that followed (Allen and Santomero, 1998). Prior to derivatives markets were genuinely formulated, the mode of dealing with corporate gambles was few, and therefore financial risks were not within the scope of managerial control. The alternatives to which the firms resorted under such circumstances were to establish plants abroad so that the risk in currency exchange rates was minimised. Some firms adopted natural hedging by attempting to equalise the currency constitution of their assets and liabilities (Santomero, 1995). Allen and Santomero, (1998) state that “During the 1980s and 1990s, markets for derivative instruments have developed and grown at a breathtaking pace, and many corporations have become active participants in derivatives markets. Since then, the range and quality of both exchange-traded and OTC derivatives, together with the depth of the market for such instruments, have expanded intensively.” The growth of the derivatives market, dynamic risk management became a vital component of current corporate strategy. This is evidenced by the fact that financial executives in companies all over the world have taken up risk management as an important objective (Bartram, 2000). But for quite some time it was believed that corporate risk management was immaterial to the worth of the firm and the controversies in favour of the irrelevancy were established on the Capital Asset Pricing Model (Sharpe, 1964; Lintner, 1965; Mossin, 1966) and the Modigliani-Miller theorem (Modigliani and Miller, 1958). CAPM had a crucial implication and it was that the shareholders need to take care of only the methodical section of total risk. This externally appeared as if, managers of firms who are supposed to act in the best interest of shareholders must be indifferent to unsystematic hedging of risks. The proposals of Miller and Modigliani’s also support the findings of CAPM. MM propositions also entail that resolutions to hedge corporate vulnerabilities with regard to rates of interest, rates of exchange and commodity costs are entirely immaterial since stockholders hold well diversified portfolios and safe guard themselves against such risks. But still managers invariably engage in hedging activities directed towards the decrease of unsystematic risk. In the material world, financial managers and treasurers think a lot about elements of capital structure and securities plan. Furthermore, the corporate utilisation of derivatives with regard to hedging rate of interest, currency, and commodity price risks is extensive and rising. Actually flaws in the capital market are pointed out and argument for the significance of corporate risk management issue is used to explain the difference in theory and practice. Scholars have been able to construct two categories of justifications for management fear with hedging of nonsystematic risk. 1. The first explanation focuses on risk management as a way to make the most of shareholder value, and 2. The second concentrates on risk management to increase managers’ private utility. Shareholder value Maximisation due to currency hedging According to a survey in The Economist (1996, p.18) focalises on “other ways of spreading risk in non-financial companies.” The article actually talks about “natural hedges” like financing an operation in home currency, and “operational hedging” like adopting a relocation of production amenities to get an enhanced match of costs to revenues. As published in a present sequence of articles in the Financial Times on corporate risk management, “In the past few years, car makers have also been addressing manufacturing risks by reorganizing large chunks of their business to offload risk to suppliers” (Financial Times 2003, p.4). Yet another illustration is Microsoft’s dependence on provisional workers: “We [Microsoft] count on them [temporary workers] to do a lot of important work for us. We use them to provide us with flexibility to deal with uncertainty” (Los Angeles Times 1997, p.D1 as quoted by Meulbroek 2002b). Thus it can be said that operational plasticity is significant for the firm to reply to unanticipated shocks in demand, engineering or regularisation (Meulbroek 2002b). One of the potential clarifications for managers’ selections of risk management activities for the sake of their firms is established on the fact that non-systematic risk will surely have its impact on the firm, making it go bankrupt or end up in financial distress. If financial distress contributes to the generation of real costs for the firm all together, then shareholders will surely be concerned in hedging this risk (Campbell and Kracaw, 1987). Furthermore, the cost of fiscal distress acts as one of the reasons for the firm performance and market rate may be directly linked to unpredictability (Mayers and Smith, 1982; Stulz, 1984; Smith and Stulz, 1985; Shapiro and Titman, 1998; Haushalter 2000). Smith and Stultz (1985) proved that the companies derive some profits by cutting down the instability of their cash flow with the help of tax structure or the continuation of costs of financial distress. At the same time in a liberal taxation system, hedging has the capacity to decrease the anticipated disbursement of taxes, consequently increasing the after tax income of the firm thereby increasing the positive effect on firm value. The authors also demonstrated that if costs of bankruptcy exist hedging would decrease the possibility of bearing these costs, which would ultimately add value to the firm. Stulz (1984) linked the inclinations of firm managers with hedging practices. Risk averse managers, whose income was connected to the firm profits, would, automatically, defend themselves by hedging procedures. The reason is that hedging would decrease the firm’s cash flow unpredictability, thereby decreased their contact to the currency risk. But under such circumstances hedging does not add firm value as it would benefit managers and the shareholders. The strength of utilising derivatives can be linked to the existing correlation between the cash flow of the firm and its future investment options. Froot et. al. (1993) formulated a model where inefficiencies in the fiscal market would make the capital cost relative to its flow of cash. Hence, the firm has to safe guard its flow of cash from variations, if in case of a negative shock; the firm could borrow at a higher rate to continue with its investment or can decrease its investment which would result in an underinvestment problem. Operational flexibility is analysed by Huchzermeier and Cohen (1996). They define that operational flexibility is the capability to swap between different global inventing strategies choices. Global manufacturing strategy options are produced by blending product options and supply chain set-up options. The authors’ squabble that with operational flexibility, the instability of the cash flow of the firm is not annihilated but overworked and this form of operational hedging uses the global supply chain network to lessen exposure against exchange rate thereby altering the firm value and reducing its obstacle of risk. Conclusion To conclude it has to be stressed that, notwithstanding the fact that the extensive body of literature on corporate risk management and the attempts that have been committed in formulating principles for hedging, there is yet to be put forward a single recognised framework which can be a guide for practical hedging strategies. There is no agreement as to what hedging principle is most significant in explicating risk management as a corporate strategy. The total advantage of hedging is the mixture of: 1. The advantage of augmented debt capability is not jointly elite from the hedging benefits of checking underinvestment issues, tax savings, modified financial obligation; or 2. Reduced agency cost of a variety of classes of the firms claimholders. Finally it can be concluded that, if the prices of using corporate risk management instruments like financial derivatives are less than the gains rendered via hedging, or any other gain apparent by the market, then risk management is a shareholder-value raising activity. We can ultimately say that if hedging determinations are competent to increase firm values then they can do so due to the following reasons: 1. The cost or probability of financial distress is reduced. 2. Taxes or transactions costs are lessened. 3. costs linked to information “asymmetries” are reduced by indicating managements opinion of the companys vistas to investors, 4. 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